The high risk of living on a low flood plain

“Flood talks between the government and insurers have reached ‘crisis point’, the industry association said, as torrential rain in parts of England and Wales left three people dead and forced hundreds from their homes.”

FT.com, November 26

I’m not sure this is really an insurance problem.

How could it not be an insurance problem?

It seems to me that there are three kinds of hard-to-insure risks. First, there are unimaginable events, “unknown unknowns”, if you like. Yet floods are all too easy to imagine. Then there are risks that are subject to what economists call adverse selection. To take an extreme example, imagine a town ruled by some all-powerful Mob. Nobody in this town is ever robbed without warning. The Mob will be sure to let you know what’s coming to you and why they think you deserve it.

Extreme case, I think.

Yes, but you can see that no insurer would touch the place, because the only people to demand insurance would be those who already know that robbery is inevitable. A similar but less extreme argument applies to health insurance, and it certainly applies to private unemployment insurance: you know a lot more about your health and employability than any insurer, so if you come shopping for insurance, the insurer might want to know the reason why.
But that doesn’t sound like a good description of flood risk.

Quite so. Now the third kind of hard-to-insure risk is stuff that’s expensive and happens quite often. I’m trying to buy a house, I’m nearly 40 and so I’m trying to buy insurance for my family in case I die or become too ill to work. This is perfectly possible: it’s just expensive, because it’s not unusual for middle-aged men to get seriously ill. This sounds like a much better description of allegedly uninsurable homes: if there is a one in five chance of a flood, and a flood is going to cost £50,000, don’t expect to pay less than £10,000 a year for flood insurance.

But that’s unaffordable for a lot of people.

Yes, but unaffordability is not uninsurability. It’s insurable but expensive.

You’re splitting hairs.

I don’t think so. If these homes actually were uninsurable the government would need to step in and cut some kind of deal with the insurance industry – exactly the kind of deal that has lasted for the past few years and seems about to unravel. But if the problem is unaffordability, trying to solve it by cutting a deal with the insurance industry is just a way of obscuring what is really going on. The real solution is simple and stark: the government needs to decide whether it wants to pay people thousands of pounds a year to live in high-risk areas or not.

And if not?

If not, then people who currently live in flood-risk areas will see the price of their homes collapse.

To what level?

To whatever price would tempt people to live somewhere that was not only prone to distressing and disruptive floods, but was also hugely expensive to insure. Which in extreme cases will be “zero”.

Pretty harsh.

It is. So there’s a good case for the government abandoning any attempt to arrange affordable insurance, while simultaneously making a one-off payment of hundreds of thousands of pounds to anyone who owns a home in a high-risk area. The price of those houses would collapse but with cash in their back pockets people could decide whether to stay or go.
A bit utopian.

Yes, I know. It won’t happen. But at least it focuses the mind. There is a general problem with many kinds of social protection – anything from unemployment benefit to the National Health Service – which is that in seeking to protect people from all sorts of unpleasantness, you are also providing an incentive to seek unpleasantness out. Unemployment benefit is an incentive to be unemployed; free ambien healthcare is an incentive to get sick.

But people don’t get sick deliberately.

No, not often, although they might take less care of themselves than they otherwise would. I’m not saying that this kind of social insurance is a bad idea; I don’t think it is. But it does have unwelcome side effects. And in the case of flood insurance, where people have a choice about where to live, and more to the point planning authorities have a choice about where to approve new building, it is not a good idea to hide these side effects under the sandbags.

7 Comments

But doesn’t the government often have an interest in furthering home ownership in these areas? There may be an interest in protecting shorelines, for instance, that is easier if the population – residents and aspiring shore residents – believes it has a stake in the region. It also furthers tourism in a region, drawing in tax dollars and creating jobs that would not exist without tge shore attraction. For the government, or society, shoreline development may not merely be viewed through the one measure of whether it is good for some particular circle of homeowners.

You stated the problem nicely (does government want to subsidize risky behavior), but promptly switch to the question of supporting home prices. Why?

The first perspective deserves more treatment. Hasn’t the recent financial meltdown resulted from individuals and institutions being pushed to take too much risk? Who should evaluate and be responsible for taking risks? Should government punish safe and responsible individuals by taxing them to subsidize less less discerning (by mistake or by moral hazard) individuals?

A quick comment regarding home prices. If you want to help the poor, redistribution in kind, in the form of socialized flood insurance hardly seems a solution. As you said, such government-granted privileges reflect into higher home prices, which hardly helps the poor (who cannot afford such houses).

Isn’t Friedman’s idea of negative income tax, or other form of monetary redistribution, preferable to in-kind benefits? At least this would avoid making the problem of risky-behavior worse concerning floods, by encouraging more stuff to be built in dangerous areas as socialized insurance does. Which cities should grow more, those in safe or in risky areas? Which society will be better off in the long-term, that which subsidizes building and owning estate in dangerous areas?

Surely this is a problem with all the insurance industry, as the industry has more and more information the benefit of general insurance decreases. As I am in my 50s, have smoked and drunk too much all my adult life; therefore quite reasonably on statistical evidence I will have to pay more for life insurance (on the other hand if I take out an annuity my pension should increase, as my life expectancy is low compared to the average).

Similarly very sensible 20 year old drivers get hammered, because they get classified as being within a high risk group.

In all cases where specific or statistical information means you have to pay higher premiums is there any clamour for a mechanism by which the low risk groups have to subsidise the high risk groups?

So why is it different for flood risks? I live in a part of Plymouth which is at about zero risk of flooding, when looking for a house I (and more especially my father) looked into flood risks. Why on earth should I subsidise those who have bought houses in high flood risk areas?

The issue is complicated by an increasing flood risk due to land use decisions by others (development, farming, tarmaced driveways etc.) and possible climate change. So increased flood costs whether picked up by households or insurers arises from multiple externalities which are unlikely to be sorted out without some form of government intervention. In this case, instead of removing the externalities, the policy was to mitigate the risk through flood defence schemes, and insurers agreed to continue providing flood cover. An interesting case of third party moral hazard when the government then cut the flood defence budget.

Much of the problem seems to be new housing built in known flood plains. In this case, surely the problem is that risk/reward balance that regulates markets is broken.

I.e. The developers who drive though the planning for houses in these flood-prone areas get the rewards and almost none of the risks. Those risks are then left to be shouldered by house-buyers and insurance companies – neither of which were directly involved in the decision to build there.

Would a planning requirement that that insurance companies be part of the approval process help in this instance? If so, how would it work, I wonder?

While people don’t get sick deliberately, there can be a rational decision whether a given state (of depression, of sore throat, of queasy feeling in the stomach, …) is “sick” or not. And that decision is certainly influenced by what the alternatives are.